More tips for bond investors
In last month's column, we discussed how bonds earn capital gains on top of interest when interest rates are falling.
By Marvin Appel, MD., PhD & Brian Hufford, CPA, CFP
In last month's column, we discussed how bonds earn capital gains on top of interest when interest rates are falling. Conversely, when interest rates rise, bonds lose principal, although they continue to receive the same dollar amount of interest payments. If you hold bonds until they mature, interest rate changes before maturity will not affect your ultimate investment results.
In fact, barring any default, purchasing a bond and holding it until maturity gives the investor secure knowledge of the ultimate return. This anticipated return is called the yield to maturity. Because the yield to maturity is known when you buy an individual bond, investment-grade bonds are considered safe investments compared to stocks.
Individuals can invest in bonds in two ways: by purchasing a portfolio of individual bonds, or by investing in bond mutual funds.
Who should buy bonds?
Success with a portfolio of individual bonds means investing at least $50,000 to $100,000 for the term of the bonds. Brokers sell bonds in minimum amounts that can range from $5,000 to $25,000 per issue. If you are planning to construct a bond ladder, you should hold on to bonds that mature in at least five different years. It is also advisable to hold bonds from multiple corporate borrowers, since news can greatly affect any one company's holdings.
Investors who may need access to their bond capital should invest only in bonds that mature before the money might be needed. Selling individual bonds before they mature (with the exception of Treasury issues) usually means taking an immediate loss on a bond's true market value and should be strenuously avoided.
If you have sufficient capital to diversify your bond holdings, you will likely get higher returns (at acceptable risk) with a portfolio of corporate bonds compared to Treasury issues. However, if you can purchase only a small number of issues or want to maintain liquidity, Treasury issues might be better.
Questions to ask
Brokers often fail to explicitly state the commission on a bond sale. More likely, the broker will buy a bond from a dealer (or from himself, if he also is a bond dealer) and then resell it at a mark-up. Most brokers are reluctant to disclose the extent of that mark-up, but it never hurts to ask.
You also should request that you be charged the lowest possible price for your bonds, since some brokers do have a range in which they have pricing discretion. (In other words, buying a bond can resemble buying a car.)
You should check the credit rating on any bond you buy. If in doubt, stick with those rated AA or better. (Bonds with a lower rating pay higher interest but are believed to have greater credit risk.) When evaluating the yield on your bond purchases, ask the broker for the "yield to worst." (Some bonds allow borrowers to prepay their loans. In this case, you do not know exactly what the course of your investment will be, so you should evaluate based on the worst-case scenario.)
Unfortunately, it's harder to comparison shop for bonds than for cars. Not every bond dealer will show you exactly the same specific issues, nor is there a source for information about a "fair price" for most individual bonds apart from U.S. Treasury debt. Ask each broker for a proposed portfolio, including overall credit quality, average maturity, interest rate sensitivity (called duration), and yield-to-worst. In some cases, buyers may get better offerings when the brokerage also deals bonds (meaning it is selling bonds from its own holdings) than when the broker acts as a middleman between buyer and seller.
If the idea of using a broker is not appealing or feasible, you have the option of investing in bond mutual funds. We will address these funds in next month's column.
Dr. Marvin Appel is CEO of Appel Asset Management. He holds a degree in biochemical sciences from Harvard College and earned his MD in 1991. He is coauthor of Systems and Forecasts. Contact him at (516) 487-7146 or email@example.com. Brian C. Hufford, CPA, CFP, is president of Hufford Investment Advisory Programs, LLC, and Hufford Financial Advisors, companies dedicated solely to helping dentists secure solid financial planning and safe investment strategies. He can be reached at (317) 848-4987.